On Wednesday, the Federal Reserve raised interest rates by 25 basis points in the first of what could be as many as six rate hikes this year.
Predictably, advisors and investors are looking to embrace fixed income assets that aren’t negatively correlated to rising rates. That conversation often includes convertible bonds and exchange traded funds, such as the American Century Quality Convertible Securities ETF (QCON).
Owing to equity-like properties, convertible bonds have well-documented histories of durability against the backdrop of Fed tightening. However, there are other reasons why a fund like QCON is relevant today. Notably, inflationary environments can highlight the allure of convertible bonds.
“It’s easy to understand why some investors are showing interest in convertibles. Inflation is already at a 40-year high and could very easily rise even further in coming months. But it also isn’t unlikely that within the next 12 to 18 months, inflation will be a lot lower than it is today. The Philadelphia Federal Reserve Bank reports that the consensus among professional economic forecasters is that inflation in 12 months’ time will be below 3%,” reports Mark Hulbert for Barron’s.
The actively managed QCON holds 133 bonds, as of the end of 2021. QCON’s duration is just 1.34 years, confirming its utility in rising rate environments. Moreover, QCON could be a valid idea for long-term investors looking for upside relative to other fixed income assets.
The Morningstar US Fund Convertibles category “average significantly outperformed the various categories of traditional bonds since 1957 and nearly kept up with stocks,” according to Hulbert. “Over the entire 65-year period, the category produced an annualized return of 9.3% versus 10.6% for the S&P 500 index, 7.2% for corporate bonds, 6.7% for long-term Treasury bonds, and 6.1% for intermediate-term Treasuries.”
While convertibles are hybrid securities, meaning they have equity and fixed income traits, the asset class isn’t highly correlated to bonds or stocks, which can provide some inflation protection. That said, because convertibles can be converted to common equity, these bonds are more correlated to stocks, and when inflation is high, as is the case today, that’s a positive.
“In all calendar years since 1957 in which inflation was higher than in the preceding year, convertible funds produced an annualized gain of 6.5%—equaling the S&P 500’s return and significantly outperforming traditional bonds,” concludes Hulbert.
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The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.
